The stock exchanges space has undergone tremendous changes over the last decade with many new entrants joining the market and automated systems driving capacities and proximity hosting services up. More changes are on the way post-crunch as new business models are tried that are less reliant on low margins and fast disappearing high volumes. David Adams maps out the road ahead as the consolidation phase begins

Despite the long boom, this last decade has not been pleasant for European stock exchanges. Technological changes, especially the rise of automated trading, smart order routing systems and the like, combined with the impact of new regulation, such as the Markets in Financial Instruments Directive (MiFID), has exposed traditional nationally-based incumbent exchanges to fierce competition from new entrants, the so-called Multilateral Trading Facilities (MTFs). Both groups then suffered after the financial crisis when volumes fell back and investment banks, whom they'd come to rely on more than their listed companies, increasingly looked to their own platforms or partnerships. The future for this part of the financial sector is uncertain, therefore, especially as further changes down the line in the clearing settlement space will also impact them.

The era of ever-increasing transaction volumes has drawn to a close at the major exchanges, declares a recent TowerGroup Viewpoint report, issued in April. It predicts transaction volumes will remain flat in 2010. Furthermore, its figures show that the major established European exchanges have failed to increase their market share in pan-European equities trading since the first part of 2008.

"Stock exchanges still have a very volume-based business model and they need to move away from that," says Bob McDowall, European research director at the TowerGroup consultancy and co-author of the Viewpoint report. "[They] planned on a continued increase in business volumes and that's unlikely to happen for the foreseeable future."

There's been a permanent change in the landscape of the exchange community in Europe, agrees John Owens, vice-president of electronic communication networks (ECNs) and stock exchanges at Transaction Network Services (TNS). "Chi-X has now reached a stage where they are almost viewed as an incumbent player, for instance, not just a cheeky upstart," he points out.

Technology has played a critical role for all the MTFs, enabling trading at speeds sometimes hundreds of times faster than those offered by old exchange systems, thus creating useful arbitrage, market making and risk management opportunities. Increased use of high frequency and algorithm-based trading has encouraged more market participants and exchanges to crowd their hardware into closer physical proximity in an attempt to reduce latency. So London - or rather, a group of data centres on the outskirts of London - is fast becoming a global data centre hub for the financial services industry as all the major European exchanges place matching engines inside them. The recent decision of NYSE Euronext to move its main liquidity data centre from Paris to a new site on the outskirts of London in Essex is a good illustration of this trend (see HERE for more).

These technology changes were visible trends before the financial crisis, but have accelerated since its onset. But the crisis had more unambiguously negative consequences for the more vulnerable new entrants. "I almost look at the credit crunch as a sharpened scalpel," says Ian-Patrick Lauder, head of trading services at the small and mid-cap London-focused stock exchange, Plus Markets. "The crisis appeared at the wrong time for a lot of the new players. It exposed the unsustainability of their low margin, high volume business models."

Some fell quickly, others had a slower death: only in April 2010, for instance, did the Nasdaq OMX Group announce the closure of its pan-European Neuro MTF (see news pages). Yet Chi-X has continued to go from strength to strength. Since its launch in March 2007, it has built up a significant market share - for example, it had 26.2 per cent of the FTSE 100 in February; 20 per cent of the FTSE 250; and more than 20 per cent of all trading in the DAX 30, AEX 25 and CAC 40 stocks. Chi-X now offers trading in component stocks of 22 indices across 14 major European markets and exchange traded funds (ETFs) and exchange traded commodities (ETCs).

"Chi-X is the only MTF in Europe that has succeeded, although I suspect there's a role for Burgundy in Scandinavia," contends TowerGroup's McDowall. "It is the only one we could categorically say has been a success. They moved very fast into the market and their technology was scalable and not too sophisticated; the functionality of it is simpler than that at Turquoise, for example."

Graham Dick, head of business development at Chi-X, is quick to counter any suggestion that its success has been based purely on first mover advantage. "There is no question that if you are first to the table you have a chance of building up your business model, but we anticipated the changes in MIFID and the need to improve latency," he says. "Volumes in the US were seven, eight and ten times more than trading in Europe and we had this new breed of customer, doing high frequency trading, with institutional customers rolling out algo trading methods and wanting to trade faster. Plus there has been an investment in bringing new customers to the market, growing the overall pie."

Now Chi-X is preparing to take the next step. "I don't think it's any secret that a number of exchanges are looking at different asset classes," says Dick. "There are obvious synergies between cash trading platforms and derivatives markets. We are certainly looking at those possibilities."

Changing business model
What of the incumbent exchanges - can they fight back? TowerGroup's McDowall believes they have been guilty of taking some of their listed companies - especially some small to mid-cap companies - for granted. "The larger, regional or international exchanges have demutualised and their shareholder profit bases, and the objectives of the different stakeholders, have changed," he says. "I think that over the last four to five years incumbent venues have focused on the trading community who put through the volume. They've got to look at additional services for listed companies now, such as information and analytical services of interest to institutional investors, listed companies and their directors."

Exchanges could also do more to exploit the resources they already possess, by finding ways of adding value to data services for listed companies and their shareholders. Selling technology may also become a more important revenue stream for them. "Our technology business is a subject we're taking very seriously," confirms Anthony Attia, senior vice-president and head of the Universal Trading Platform (UTP) programme at NYSE Euronext. "We are aiming in 2015 to have a $1 billion revenue business."

Exchanges could also change the way they offer services, with further exploitation in future of mobile service channels, something already underway in the Far East. "In the Chinese market you can trade at the exchange through your mobile, which is something you don't find in the mature markets yet," says Susanne Kloess, Accenture's managing partner for capital markets, Europe, Middle-East and Africa (EMEA). "The reason you can do that is because the exchange not only covers your trading but can also watch your cash account. Only if you have enough cash will they accept an order."

Finally, incumbent exchanges and MTFs alike may well move with Chi-X into other asset classes. "You'll see a move into derivatives by some of the MTFs, so they can trade cash and derivatives on the same book," says Plus Markets' Lauder. "I think you'll start to see that over the next 12 to 24 months." TowerGroup suggests that capital and risk constraints being imposed by regulators on broker-dealer activity in the over the counter (OTC) markets may help make this happen.

London Stock Exchange
Yet it is still very difficult for many exchanges to build and implement an infrastructure through which it can trade different asset classes via the same matching engine, largely because of the incumbents' complex existing legacy architectures. These are still an occasional source of embarrassment. The London Stock Exchange (LSE), for instance, suffered a couple of high profile technical problems last year due to integration problems with its old systems. The venue will be hoping the chances of such problems in future have been lessened by its purchase of trading technology specialist MillenniumIT, for £18 million, in October 2009. LSE Group hopes to save about £10 million per year from 2011/2012 by being able to bring systems development in-house onto a new Linux-based platform, replacing its existing Microsoft .NET solution.

"For the LSE speed became a really important issue," says MillenniumIT CEO, Tony Weeresinghe, now of course a partner in their change programme. "The new Linux-based system will bring them back not just in line with the other players, but probably into the lead in terms of performance and latency. The other benefit is our business innovation tools, which will help them launch new products and services very quickly." Testing of the system, which is replacing the old TradElect platform, began in April and the LSE plans to go live in September. So far, says Weeresinghe, everything is on schedule. "I think we know where we want to go," he says. "We want to be more nimble and mobile, and we want to be a multi-asset exchange."

The other striking move made by the LSE in recent months was the acquisition of Turquoise, an MTF originally launched and owned by a consortium of investment banks. Under a deal announced at the turn of the year, the LSE Group took a 60 per cent stake in Turquoise, merging it with its own dark pool, Baikal. It is building a new infrastructure for the joint venture based on MillenniumIT technology, planning a 'big bang' migration of the trading platform in September. A test platform was scheduled to become available in May. "Turquoise was pan-European and it made sense for us to get into that space with a partnership, so we don't have to start from scratch again," explains Weeresinghe.

In April 2010 Turquoise announced the launch of a US securities trading service, making it the first MTF to offer trading of US-listed equities, ETFs and ADRs (American Depositary Receipts) in European trading hours, in addition to pan-European equities trading in another 19 markets. "That to me demonstrates that there's a change coming with the LSE," says Plus Markets' Lauder. "I have no doubt that over the next 12 months you'll see a big fight back coming from them."

Another of the incumbent exchanges, NYSE Euronext, has also taken significant strides in the past two years to protect its established position [buying Euronext a few years ago was of course one of the first shake ups of the old order]. "We launched major initiatives in 2008 with the Universal Trading Platform (UTP), for cash and derivatives, supporting both US and European markets," says Anthony Attia. "That was a major change, decommissioning all the legacy systems and launching this unique platform with a global network." The UTP is based on a Common Customer Gateway, which provides clients with multi-format order entry and access to multiple trading platforms; market data distribution enabling the creation of new data products; and SFTI, the Secure Financial Transaction Infrastructure, a high performance backbone that enables access to NYSE Euronext services through a single resilient high speed network.

"We believe that there is room for more efficiency improvements in Europe," says Attia. "Fragmenting the liquidity is a short-term effect of MIFID, but the expectations from investors and regulators are a better playing field between exchanges on one side and MTFs on the other, and also more transparency and regulation on crossing networks and dark pools. This is probably where the inefficiencies lie. The other interesting subject is the clearing and settlement space, where we still have a lot of inefficiencies. I'm expecting more activity there."

Clearing and settlement
Accenture's Kloess also predicts that exchanges will seek improvements in the clearing and settlement area. "Trading venues are trying to move down the value chain, through an alliance or third party partnership, to offer clearing and settlement, so you would have an end-to-end process," she explains. "The margins are quite small, but you can still differentiate on clearing and settlement." With falling or stagnant equity volumes you will see this trend in evidence more and more.

The subject is on Chi-X's agenda too. "There has been a lot of discussion around reducing the overall frictional cost of trading," says Dick. "We're very keen that the costs should continue to fall."

In February 2009 Chi-X announced plans to introduce a 'user choice' clearing model based on three-way central counterparty (CCP) interoperability. It would allow clearing participants to choose a single CCP for activity relating to a given market segment for various different trading venues. "It will mean competition between central counterparties, so there is competition on price," explains Dick. "Four European counterparties have now put in a bid for an interoperability solution. We're expecting the regulators to come back with approval on that in three or four months. We're certainly hoping we might get approval before the end of the year."

It seems that only by trying to go faster and further, by stretching into new service offerings, will trading venues be able to safeguard future prosperity. "It's clear that because of the inefficiencies of the incumbent exchanges, Chi-X have crept into [the electronic trading marketplace]," says MillenniumIT's Weeresinghe. "But there's more work for them to do. If the incumbent exchanges change the game, and take market share back, they will have to find new revenue methods to stay afloat. I think they will survive, but if the incumbent exchanges become much more efficient the new venues will have a harder time."

Further consolidation, certainly among MTFs, seems inevitable. "We believe Europe will probably end up with three or four pan-European exchanges and we intend to be one of those," says Chi-X's Dick. "We are already the largest pan-European exchange [depending upon which figures you look at], but we would expect the likes of the LSE, NYSE Euronext and Deutsche Börse to be there too." Right now, you wouldn't bet against them, but the one thing of which we can be certain is that no-one can take anything for granted in this market. The road ahead is rocky and uncertain still.

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